If you run a business or you're in charge of monitoring a company's financial health, you need to know how to measure business liquidity.
In this guide, you'll find some working examples and learn why liquidity is important for business. Plus you'll learn how to measure it and how to improve your organisation's liquidity.
What is liquidity?
Liquidity is how easily an asset can be turned into cash. In your business, you should have a combination of liquid and illiquid assets. Liquid assets include anything that you could convert to cash within 12 months, like money in your bank account or easy-to-sell investments. Illiquid assets include things like property or rare collectibles because it can take a lot longer to find a buyer and collect payment for these items.
In financial accounting, liquidity measures your ability to pay off debts your business owes in the next year. Simply put, when you're liquid, you'll be able to pay your upcoming bills.
Liquidity ratios are expressed as numbers, often with a digit after the decimal point. The numbers refer to the liquid assets of your business compared to its shorter-term liabilities, so a ratio of 2.5 suggests you could theoretically pay your upcoming bills two and a half times.
Why is liquidity important in business?
Liquidity is important in business for several reasons. If your business has good liquidity, it's much less likely to fail. Liquidity is also important if you need to secure business finance or business loans since investors and creditors are more likely to lend to you if you have a high liquidity ratio.
Poor liquidity can be a sign of financial instability and can negatively impact your business. For instance, if you don't have the working capital to pay suppliers, they may stop supplying you. Or if you get behind on tax payments, you could be looking at substantial penalties or legal action.
How to measure liquidity
To measure liquidity in your business, you have the choice of three common ratios, all of which you calculate by dividing your current assets by your current liabilities. These are current ratio, quick ratio and cash ratio.
Each varies in strictness and complexity. When we talk about the strictness of a liquidity ratio, we refer to the types and number of assets you include in your calculation. Since you're dividing your assets by your liabilities, the fewer assets you include, the harder it'll be to get a high ratio. So, a ratio that only includes cash as a current asset is seen as stricter than one that includes accounts receivable, marketable securities or inventory.
In all three ratios, current liabilities include both accounts payable and accrued expenses, but what you include in your current assets varies depending on which ratio you use.
It's important to note that the assets and liabilities used in these calculations are current only – that is anything you expect to convert into cash within 12 months or that you're liable for within this timeframe.
Assets that take longer than 12 months to convert are considered non-current assets and include things like property, equipment or vehicles. Similarly, non-current liabilities are financial obligations that you're not expected to settle within 12 months such as long-term loans or property leases. You don't include non-current assets or liabilities in your liquidity calculations.
Let's look at each of the ratios in more detail.
Current ratio
The current ratio is the easiest for most business owners to understand and apply. It compares your short-term liabilities to your short-term, or current, assets. Since it's the most lenient of the three ratios in that it includes the most assets, you should be aiming for a current ratio of between 1.5 and 2.0 or higher, depending on the industry.
Current ratio formula
The current ratio formula is:
Current Ratio = Current Assets ÷ Current Liabilities
In this case, current assets include:
Cash and cash equivalents (such as short-term investments like money marketing funds)
Marketable securities (such as stocks and bonds with less than a year to maturity)
Inventory
Quick ratio
The quick ratio, also known as the acid-test ratio, is similar to the current ratio in that you divide your current assets by your current liabilities. For the quick ratio, however, you exclude inventory from your total current assets. Since you include fewer assets in the formula, the quick ratio is considered stricter than the current ratio so the recommended minimum ratio is lower. If using the quick ratio to measure your liquidity, you should aim for a ratio of 1.0 or above.
Quick ratio formula
The quick ratio formula is:
Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities
In this case, current assets include:
Cash and cash equivalents (such as short-term investments like money marketing funds)
Marketable securities (such as stocks and bonds with less than a year to maturity)
Accounts receivable
Cash ratio
The cash ratio is the strictest of the three liquidity ratios because it counts cash or cash equivalents as your company's only liquid assets. The formula still technically divides your current assets by your current liabilities, but you exclude both accounts receivable and inventory from your current assets.
This is the best ratio to use if you need to work out whether your company would stay solvent in a crisis as it highlights your ability to use your most liquid assets to cover short-term or current liabilities.
Cash ratio formula
The cash ratio formula is:
Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities
In this case, cash equivalents can include highly liquid marketable securities such as stocks and short-term bonds.
What is a good liquidity ratio?
A good liquidity ratio is generally anything above 1. A ratio lower than 1 suggests your business can't afford its current liabilities. Equally, a higher ratio suggests that your business would be able to withstand periods of restricted cash flow.
However, what's considered an acceptable ratio depends on the type of ratio you use. Since the cash ratio includes fewer assets than the current ratio, a company with good liquidity is expected to have a much higher current ratio than cash ratio.
Example of liquidity
For an example of liquidity, let's look at a balance sheet from Phillips & Co Plumbing and work out their liquidity ratios.
Current Assets
Cash and cash equivalents $25,000
Accounts receivable $21,000
Marketable securities $10,000
Inventory $15,000
Total Current Assets $71,000
Current Liabilities
Accounts payable $18,000
Accrued expenses $11,000
Total Current Liabilities $29,000
Current ratio: divide the total current assets ($71,000) by the total current liabilities ($29,000). This results in a current ratio of 2.5
Quick ratio: first, subtract the inventory ($15,000) from the total current assets, which leaves us with $56,000 in current assets. Then divide this by the total current liabilities ($29,000) to get a quick ratio of 1.9
Cash ratio: We only include cash, cash equivalents, and marketable securities, which gives us $35,000 in current assets. We divide this by the total current liabilities ($29,000) to get a cash ratio of 1.2
These ratios suggest that Phillips & Co Plumbing can meet all their financial obligations using their current assets in the next 12 months.
How can a business improve liquidity?
A business can improve liquidity in a few ways. Here are some of the approaches you can take:
Improving your cash flow management
Improving your cash flow management can drastically reduce your liquidity risk. Many businesses fail due to cash flow problems, so having effective processes in place can help you identify and address problems before they affect your business.
Accounting software can help you better manage your cash flow. You can streamline invoicing and automate payment reminders, saving you time. Further, you get the spending insights you need to reduce overhead costs, business expenses and operating costs so you can boost your cash flow and business liquidity.
Creating regular cash flow forecasts
Creating regular cash flow forecasts is a type of financial forecasting that lets you see potential shortfalls in your annual budget. By anticipating these, you can take action to protect your company's liquidity.
Optimising your working capital
Optimising your working capital includes effective inventory management, promptly paying debts and expenses, managing invoicing efficiently, and regularly reviewing expense reports. If your business has positive working capital, it will likely have healthy liquidity ratios.
Implementing a liquidity buffer
Implementing a liquidity buffer is a good idea if your business experiences regular cash flow fluctuations. This involves setting aside some liquid assets you can quickly convert to cash if you hit a tricky patch.
Liquidity FAQs
What causes a lack of liquidity?
A lack of liquidity can be caused by various factors, some of which are beyond your control, such as market fluctuations or global events. You can limit your liquidity risk by optimising your working capital, creating regular cash flow forecasts, and ensuring effective cash flow management.
Is a higher or lower liquidity ratio better?
A higher liquidity ratio is almost always better than a lower liquidity ratio. Your current assets should exceed your current liabilities for your business to succeed. That is, you should always have enough money to pay your bills. For example, if your current ratio is 3.0, you can cover your current liabilities three times over.
What is an unhealthy liquidity ratio?
An unhealthy liquidity ratio is anything under 1.0, which implies that you don't have enough cash to meet your company's liabilities. If you calculate your liquidity using the cash ratio, a lower ratio may be acceptable, but you should still aim for 1.0 or higher.
Can a high liquidity ratio be bad?
Yes, a high liquidity ratio can be bad in some situations. For example, if your business has a cash ratio of 9.0, you may have large reserves of cash that are gathering figurative dust. This means you're missing the opportunity to make longer-term investments to benefit your business. Investors want to see that you're using your capital wisely, so many will be put off by such high liquidity ratios.
Can day sales outstanding be used for liquidity?
Day sales outstanding (DSO) can't be used for liquidity, as DSO measures a different element of your business. Where liquidity in business measures your ability to pay your upcoming liabilities using your current assets, DSO measures how long, on average, it takes you to collect your account receivables after making a sale.
Keep your business liquid and look out for leaks
If you're a small business owner, measuring liquidity is just one of the many important tasks you must do regularly to ensure you stay on track. Getting to grips with measuring and tracking financial ratios can be challenging, but you don't have to do it alone.
MYOB's accounting and financial reporting software lets you easily track your liquidity health so you can focus on growing your business. Get started today.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.